The failure of your startup and subsequent exit plan will raise a host of conflicting concerns, such as your reputation in the VC community, the well-being of your employees, and the preservation of your company's work. These concerns often lead to paralysis and a hasty winding down of operations once the funding dries up.
It does not have to end this way. If addressed early in the winding down process, your company or its assets may live to see another day through bankruptcy or one of its many alternatives.
In short, a bankruptcy filing halts almost all creditor and investor collection action against a company while the company attempts to restructure its obligations or, as is often the case, liquidate its assets. Bankruptcy is a powerful tool. It allows a company to sell its assets, including intellectual property, free and clear of all liens, claims and encumbrances. A company may also rid itself of its office lease obligations and other creditor claims, leaving these creditors only with an unsecured bankruptcy claim. Claims of creditors and investors can be reduced or wiped out with the blessing of the Bankruptcy Court. Any startup devising an exit strategy from the market would be well-served to consult with an experienced corporate bankruptcy attorney. Here are a few thoughts to consider.
What Is the Nature of Your Funding?
The first step in devising an exit strategy is to determine the rights of your creditors and investors. Did your investors take an ownership interest in your company, or were your investors provided collateral in the form of your company's assets? In bankruptcy or other liquidation scenarios, this is a critical distinction.
A creditor secured by your company's assets gets to collect 100% of its debt from the proceeds of the company's asset sale. Moreover, a secured creditor may "bid in its lien" if it is unsatisfied with the offers made for the assets by third parties (meaning that the secured creditor may take title to the assets without offering any money for the transaction).
...your landlord may be entitled to payment from the sale of assets prior to your investors.
On the other hand, an equity investor is ordinarily at the bottom of the priority list, only receiving payment from a sale of the company once all creditors are 100% paid. Yes, that means that your landlord may be entitled to payment from the sale of assets prior to your investors.
This provides your company with incredible leverage against equity investors in a restructuring scenario, either to obtain more funding or to work towards a cooperative restructuring of the company. One only needs to look at the losses incurred by the investors in the Solyndra bankruptcy to see that bankruptcy may be the doomsday scenario for investors without a security interest in a company's assets.
Bankruptcy Does Not Protect You Personally
While your company's bankruptcy filing may halt all collection actions against your company, it does not protect you personally. If you provided one of your creditors or investors with a personal guaranty of your company's obligations, your company's bankruptcy filing does not stop a collection action against you.
Bankruptcy Can Be a Cooperative Process
Bankruptcy does not need to involve a prolonged fight between your company and its creditors and investors. Modern bankruptcy often can be a cooperative process. For example, a "pre-packaged bankruptcy" is where a company and its creditors plan for a sale of the company's assets shortly after the bankruptcy filing, with a series of other events agreed upon between the major parties. Other times, your investor will agree to provide the company with financing during the course of the bankruptcy case, affording the company with time to find other financing or to schedule an orderly liquidation of the assets.
The benefit of restructuring your company or selling its assets in bankruptcy is finality... The downside is cost...
The benefit of restructuring your company or selling its assets in bankruptcy is finality. It is very difficult to challenge actions approved of by a Bankruptcy Court after the fact. The downside is cost. Due to bankruptcy procedures, including the necessity for Court approval for almost any action taken outside a company's ordinary course of business, legal fees for bankruptcy can easily reach six figures.
The good news is that there are many alternatives to bankruptcy which may be attractive to your company, particularly if you and your investors are only looking to liquidate the company's assets. Most states allow a company to enter into an assignment for the benefit of creditors, or ABC, whereby a company's assets are assigned to a trustee (usually a restructuring professional) which agrees to liquidate the company's assets and distribute the sale proceeds pursuant to a trust agreement. If a state requires court supervision of an ABC, it is usually minimal.
Another nonbankruptcy sale process is a sale of personal property under the Uniform Commercial Code. This is an attractive option for many startups, particularly where intellectual property is the only salvageable asset.
There are other options available, and many other issues to consider, when devising an exit strategy. Startups should be more aware of the bankruptcy and restructuring options and the possibility that it may give the company or its assets a new lease on life.
[Rick Bixter is an associate in Holland & Knight's Chicago office. He practices in the areas of corporate restructuring, bankruptcy, and media and entertainment.]